Military Might: Two Top Defense Plays

11/25/2015 7:00 am EST

Focus: STOCKS

John Eade

President and Senior Analyst, Argus Research Group

John Eade, analyst with the top-notch Argus Research, has upped his price targets and buy-ratings on two leading global defense contractors. Here's his latest assessment.

Northrop Grumman (NOC) is a leading global defense contractor with a focus on aerospace and, increasingly, electronic programs. The company’s balance sheet is clean and management has a history of meeting and beating analyst expectations.

Northrop was recently selected by the US Air Force as its partner on the Long-Range Strike Bomber. This program is expected to result in 80-100 bombers, at a cost of $500-$550 million each, over the next 15-20 years.

Northrop Grumman has posted 10% compound annual EPS growth over the past five years, driven by low single-digit top-line growth, margin improvement, and aggressive share buybacks.

NOC shares appear attractively valued; on a technical basis, the shares are in a positive trend of higher highs and higher lows that dates to August 2011.

To value the stock on a fundamental basis, we use a peer and multiple comparison model. NOC shares are trading at 17-times our 2016 estimate, near the high end of the historical range of 7-18.

On a price/sales basis, the shares are also trading above the midpoint of the five-year range. The dividend yield of about 1.9% is at the low end of the five-year range and below the peer average.

NOC’s multiples are generally in line with or slightly above industry averages. Yet given the company’s consistent earnings history, we think that the stock merits a premium valuation.

We are raising our rating on Raytheon Co. (RTN); the company is generating strong cash flow and aggressively returning cash to shareholders through increased dividends and share buybacks.

In addition, Raytheon continues to see opportunities in the cyber protection market, driven by evolving threat levels.

In the second quarter, it signed an agreement with Vista Equity Partners to form Raytheon/Websense, a jointly owned cyber-security company.

During the third quarter, it bought back 2.4 million shares. In April 2015, it raised its quarterly payout to $0.67 per share, or $2.68 annually, for a yield of about 2.3%. The dividend appears secure and we expect it to grow.

RTN’s multiples are generally in line with industry averages. But we think that RTN merits a higher valuation, as we expect management’s focus on international and cyber-security businesses to pay off over time.

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